Contrary to Rumor, Central Banking Is a Political Act

By the Editors -
Aug 29, 2012

Central bankers from around the
world meet in Jackson Hole, Wyoming, starting Thursday for the
Federal Reserve’s annual symposium. They have a lot to discuss;
more, it’s safe to say, than they would like.

The experience of the past several years has assaulted the
core of what central bankers once took for granted about their
role. A comprehensive rethink is required. At the top of the
list is a sensitive subject: How should central banks balance
the goals of low inflation and low unemployment? The question is
harder than economists used to think, and it’s an uncomfortable
one for the Jackson Hole crowd because it’s about politics as
much as economics.

Before the most recent recession, the question had mostly
been set aside. Economists decided that the goals of price
stability and high employment weren’t really in conflict. In
1969, Milton Friedman and Edmund Phelps showed, in a seminal
finding of modern macroeconomics, that there’s no long-run
trade-off between inflation and output. That is, tolerating
higher inflation doesn’t buy you faster economic growth.

What a convenient finding that was for central banks. It
meant they could be told to keep prices stable, and then be left
alone to get on with it. Independent central banks would be
better at keeping inflation low than would those under the
political control of finance ministries, often tempted to print
money to pay for their programs. And if low inflation didn’t
hurt growth, why not set them free?

Price Stability

This thinking guided the design of the European Central
Bank in the 1990s. European governments gave it a primary goal
of price stability and shielded it from government interference.
They told the ECB never to print money to buy public debt. Many
other central banks had their rules tweaked to similar effect.

The rules in the U.S. haven’t been so clear-cut. The Fed
has a dual mandate of stable prices and maximum employment, and
the latitude to decide what that means. This wider discretion is
exactly what many of the Fed’s conservative critics in Congress
now object to. They want the narrower focus on stable prices
that is written into many other central banks’ rules, and then
some.

The recurring vogue for the gold standard -- the Republican
Party is calling for yet another commission to examine the idea
-- is all about denying the Fed discretion. With a truly fixed
exchange rate, monetary policy is abolished: Fixing a designated
price (under a gold standard, the price of gold) puts the Fed on
autopilot.

Many U.S. conservatives also want the Fed to be more
strictly audited. Republican presidential nominee Mitt Romney
just backed this idea. His running mate, U.S. Representative
Paul Ryan, wants tougher audits, a single anti-inflation mandate
and, ideally, a dollar pegged to the prices of commodities.
Again, the aim is to tie the Fed down.

This anti-inflation obsession borders on derangement.
Inflation is very low -- so low that deflation is a
real concern. Falling prices disrupt an economy (especially one
burdened with debt) far more dangerously than rising prices do.
Also, the recent recession has shown that keeping inflation low
isn’t enough. The short-term trade-off between low inflation and
low unemployment is real. And in a recovery with protracted
deleveraging, like this one, the short term isn’t as short as
Friedman and Phelps thought.

Gold Bugs

Contrary to what gold bugs and other Fed-bashers say, the
Fed’s dual mandate and its policy of quantitative easing --
buying bonds to nudge down interest rates -- have been vital
strengths, not weaknesses. They have helped to support demand
and bring unemployment down, albeit slowly. Fiscal paralysis in
Washington made the Fed’s unorthodox measures all the more
necessary. Far from being reckless, the Fed has been too timid
and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.

Consider the European alternative. The ECB is pushing the
euro area back into recession with its preoccupation with low
inflation plus a reluctance (or inability) to use QE.

But there’s a catch, and it’s a big one. If the short-term
trade-off between inflation and unemployment is real, and
central banks have to strike a balance between the two --
putting aside concerns about inflation until the recovery is on
a surer footing -- how can you say central banks should be
shielded from political interference? If they are making
political choices, they can’t expect to stay above politics.
There’s no easy answer, which is why the discussions at Jackson
Hole will probably shy away from the question.

We suggest looking at an old idea that is again attracting
attention among monetary economists. Recast the target that the
Fed and other central banks are told to follow. Instead of a
target for low inflation plus an additional primary or secondary
target of high employment, focus on the money value of output --
nominal gross domestic product unadjusted for inflation. This
combines prices and output in a single number.

Suppose the target was 5 percent. Over the longer term,
with the economy growing at 2 percent or a little more,
inflation would be 3 percent or a little less, similar to the
inflation targets most central banks (including the Fed) have
adopted. Here’s the advantage: In the short term, the Fed would
be on target if the economy were growing at 5 percent and
inflation were zero, or if the growth were zero and inflation
were 5 percent.

In other words, the system would call for faster-than-
normal growth when inflation is too low, and faster-than-normal
inflation when the economy is in a slump. Setting a nominal GDP
target wouldn’t be telling the bank to choose between so much
inflation and so many jobs, so you could still grant operational
independence.

It’s not quite so tidy, of course. The bank would still
have to decide how quickly to bring demand back to target if it
overshot or undershot, and this could be politically
contentious. Targeting nominal GDP raises technical issues,
including how to specify the mandate. The idea has serious
academic credentials, but some scholars have expressed doubts.

We think it’s worth a careful look, and we’re convinced of
one important advantage: This approach would make the bank’s
actions easier to understand and explain.